A Primer On How To Trade Gold And Gold Stocks: Part 1

After declining a little in the April-to-May period and remaining steady during most of the summer, gold prices have resumed their upward surge, increasing as much as 10% in the last three months alone. Interest in the precious yellow metal rebounded with the announcement of the third round of quantitative easing (QE3) by Ben Bernake on September 13. The fact that QE3 does not have a timeline and is an open-ended commitment by the Federal Open Market Committee (FOMC) is even better for gold. In the next 12 months, gold prices will be closely linked to QE3, and we expect them to go higher.

Source: Kitco

Monetary policy (real interest rates), inflation, oil prices, foreign exchange rates, jewelry demand, and central banks' gold reserves are the main drivers of gold price. In the first part of our two-part series on gold we will discuss, along with key drivers of gold prices, what QE3 means for gold prices and possible changes in gold prices in 4Q12 and 2013. In part two, we will share our thoughts on the best gold stocks to buy.

Quantitative Easing, Inflation, and Gold

Historically, gold has been a good inflation hedge. Since the early 70s, gold prices in U.S. dollar terms and U.S. inflation have maintained a very strong correlation. However, the last 10 years showed a different picture. In the last decade, gold prices rose nearly every year, from a low of $310.75/oz to a high of $1,990/oz. Inflation on the other hand remained low, from 1.59% in 2002 to recently reported figures of 1.69% in August 2012. Though we do see a divergence in this relationship in the short and intermediate terms, in the long run, as evident from the chart below, this relationship does hold.

On September 19, 2012, Bank of Japan (BoJ) followed the Fed and announced to expand its treasury purchase program by 10 trillion yen to 55 trillion yen. The move is widely seen as an attempt by BoJ to prevent the yen from appreciating against the dollar. The ECB has already committed to unlimited bond buying.

On the announcement of QE3, the U.S. five-year breakeven rate, which serves as an indicator of inflation expectations, rose to above 3%, and is currently at 3.03% (see chart below). We expect these loosing monetary policies by central banks to put upward pressure on inflation and be supportive of gold for most of 2013.

Source: Bloomberg

Oil Prices and Inflation

Historically, gold prices have also had a strong correlation with oil-led inflation. Inflation goes up with rising oil prices and it leads to more investment in gold as it is widely perceived as a safe haven, an inflation hedge. However, this relation changed in the last two years when gold continued its upward rally but oil prices retreated from their record peaks in the Arab spring. A combination of global austerity measures, the eurozone debt crisis, and sluggish demand from economies like China and India has caused a dip in oil prices in more recent periods. However, just like in the case of inflation and gold prices, this relationship also holds in the long term. As you can see from the graphs below, oil prices (left) and gold prices (right) have both increased in the past 10 years.

Click to enlarge Source Infomine.com

Source: kitco.com

Quantitative easing is expected to devalue the dollar and, historically, this has resulted in higher commodity prices, including those of oil. On the other hand, the opportunity cost of not producing extra oil has fallen dramatically for oil producers. The U.S. interest rates are so low that most of the OPEC countries earn nothing by investing in low-yielding U.S. Treasuries. Countries like UAE, Qatar, and Kuwait have established sovereign wealth funds and wider investment mandates, which have helped resolve the problem of foreign reserve allocation. But many others, including Algeria and Saudi Arabia, still invest a bulk of their foreign reserves in treasuries. All these factors, combined with Saudi Arabia's budgetary needs, point toward higher oil prices and in turn high gold prices.

Foreign Exchange Rates

Historically gold had a negative relation with the U.S. dollar. Gold prices are typically dominated in U.S. dollar and as the U.S. dollar depreciates the dollar priced gold becomes cheaper for holders of other currencies and the prices of the precious metal appreciates. This relationship might break in the short term, as we have seen in the past couple of years where both gold prices and the dollar had made gains, or during periods of extreme risk aversion, such as the deepening of the sovereign debt crisis in Europe where the U.S. dollar and gold both served as safe havens for investors fleeing Europe, but the relation tends to hold true in the long run.

As can be seen in the chart below, while the U.S. dollar has largely remained unchanged in the past five years, shares in SPDR Gold Trust (NYSEARCA:GLD), an investment trust that holds gold and issues shares in exchange for gold deposits, have gone up by more than 130 percent. The relationship remains the same even after the inclusion of EURUSD.

Click to enlarge

Source: CNBC

Source: Marketwatch

The latest round of quantitative easing is expected to put a downward pressure on the U.S. dollar. The currency is expected to depreciate against the sterling and yen. On the other hand, euro appreciation will be limited by ongoing uncertainty due to the sovereign debt crisis. As discussed above, the depreciation of the dollar tends to be a positive sign for gold, and prices of the metal are expected to increase in 4Q12 and 1H13.

Real Interest Rates(Monetary policy)

Gold prices have an inverse relationship with real interest rates. When the Federal Reserve relaxes its monetary policy, real interest rates fall and investors are attracted more toward assets like gold. Low real interest rates mean low returns in treasuries, which leads investors to invest in more risky assets in search of higher returns. Low real interest rates also lead to high inflation expectations and, as discussed earlier, gold is considered a good inflation hedge; investors buy gold to hedge against expected inflation. Expansionary monetary policy is also a signal to investors that the economy is not in a good state, which leads investors to safe havens such as gold. Lower interest rates also lead to depreciation in the dollar as the U.S. currency's demand goes down; this again leads to higher gold prices in U.S. dollars terms.

The inverse relationship between real interest rates and gold prices is clearly evident from the charts above. Whilst gold increased by more than 500%, from a low of $310.2/oz to a high of $1900.30/oz in the past decade, real interest rates during the same period have dropped to -0.82% from 2.25%.

Gold prices in last 10 years

(Source:Kitco)

Real Interest Rates in the last 10 years

Click to enlarge

(Source:US Treasury)

The recent round of quantitative easing is expected to put upward pressure on inflation and lower the real interest rates (real interest rates = nominal interest rate - expected rate of inflation). The decrease in real interest rates serves as another incentive for investment in gold.

Supply and Demand

Unlike for other commodities, supply and demand does not play a huge role in determining gold prices. This is largely due to the availability of huge above-ground stocks of gold, which are estimated to be 171,300 tonnes (source: world gold council).

China and India remain the biggest consumer markets for gold (Source: World Gold Council). Combined demand for jewelry, bars and coins amounts to 45% in these two countries. Jewelry demand in India had a noticeable drop of 30% year-on-year. Investment and jewelry demand collectively fell by as much as 38% year/year. A worsening economic condition, hike in taxes, and more importantly, record high prices (Indian rupee depreciated by as much as 15% in the last year, before regaining some strength) are the main reasons for a decline in Indian gold demand. Poor monsoon rains, which dented available income of the farming community, also resulted in disappointing demand.

INRUSD 1-year exchange rate history

Click to enlarge Source:dollars2rupees

Gold prices in INR, euros, and dollar (WGC)

Click to enlarge

Despite the high prices, in the long term, the Indian market still remains significant. Once the effects of quantitative easing fade, the dollar appreciates, and short-term investors exit the market, the demand from Indian consumers will remain very important for the gold market.

In the first quarter of 2012, China overtook India as the world's top gold consumer. Both inflationary pressures and the growth of the Chinese middle class have supported the growth trend in gold buying. However, China's investment and jewelry demand was down 7% in 2Q12 compared with the same quarter last year. Though demand is expected to be lower compared with previous years, Chinese demand is expected to pick up in 4Q12 and in 2013 due to high inflation expectations and depreciation in the dollar.

Sluggish demand from Indian and Chinese consumer markets was offset by official sector demand. Official sector demand more than doubled from Q2'11 and accounted for 16% of the overall global demand. Countries that added to their holdings in the last quarter include Russia, South Korea, Paraguay, and Kazakhstan - WGC.

Other factors

Other factors include political tensions, civil unrest, and financial market shocks. As you might have noticed, these are times of uncertainty and investment in gold further establishes its status as a safe haven.

In the part 2 we will discuss gold stocks that offer value and pay dividends. Gold equities have been underperforming the gold price and we will analyze which gold stocks can see a catch-up rally.

Note: Extreme period of risk aversion, such as increased uncertainty in the eurozone, particularly for a country exiting the eurozone, serves as the main risk to our gold outlook. In such a scenario, investors would turn to U.S. Treasuries and the U.S. dollar.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Business relationship disclosure: The article has been written by Qineqt's Basic Material Analyst. Qineqt is not receiving compensation for it (other than from Seeking Alpha). Qineqt has no business relationship with any company whose stock is mentioned in this article.